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What Is Real Return?

Real return represents the actual increase in an investor's purchasing power over a given period, after accounting for the effects of inflation. It is a critical metric within investment performance analysis because it provides a more accurate picture of an investment's growth than its stated return. While a positive investment return may appear favorable, if the rate of inflation exceeds that return, the investor's ability to buy goods and services has actually diminished. Focusing on real return allows investors to understand if their wealth is truly increasing, merely keeping pace with rising prices, or eroding over time.

History and Origin

The concept of distinguishing between nominal and real values in economics gained prominence with the understanding of inflation's pervasive impact on economic variables. While not attributed to a single inventor, the Fisher Equation, named after economist Irving Fisher, formalized the relationship between nominal interest rates, real interest rates, and inflation. Fisher's work in the early 20th century highlighted how nominal interest rates could be decomposed into a real rate and an inflation premium, profoundly influencing the way economists and investors perceive the true cost of money and the true return on investments. This foundational insight underscores the necessity of considering inflation to gauge the real profitability of an investment portfolio. The U.S. Bureau of Labor Statistics (BLS), for instance, has been systematically collecting and publishing the Consumer Price Index (CPI) for over a century, providing essential data for calculating real returns and understanding inflation's historical trajectory.⁴

Key Takeaways

• Purchasing Power: Real return measures the true gain or loss in an investor's purchasing power, adjusting for inflation.
• Inflation's Erosion: A positive nominal return can still result in a negative real return if inflation is high, meaning wealth is eroding.
• Long-Term Wealth Preservation: Achieving positive real returns is essential for long-term wealth accumulation and maintaining an investor's standard of living.
• Informed Decisions: Understanding real return helps investors make more informed decisions about asset allocation and financial planning.

Formula and Calculation

The real return can be calculated using the following formula:

$\text{Real Return} = \frac{(1 + \text{Nominal Return})}{(1 + \text{Inflation Rate})} - 1$

Where:

• Nominal Return: The stated return of an investment before adjusting for inflation (e.g., the interest rate on a bond or the percentage gain on a stock).
• Inflation Rate: The rate at which the general level of prices for goods and services is rising, typically measured by the Consumer Price Index (CPI).

For smaller inflation rates and nominal returns, a simpler approximation can be used:

$\text{Real Return} \approx \text{Nominal Return} - \text{Inflation Rate}$

This approximation is less accurate when dealing with higher rates of return or inflation. For example, if a bond yields 5% (nominal return) and inflation is 2%, the approximate real return is 3%. Using the precise formula, the real return would be (\frac{(1 + 0.05)}{(1 + 0.02)} - 1 \approx 0.0294) or 2.94%.

Interpreting the Real Return

Interpreting the real return involves assessing whether an investment has genuinely increased an individual's financial standing. A positive real return indicates that the investment has outpaced inflation, preserving and growing the investor's purchasing power. This is the primary goal for long-term investors. A zero real return means the investment's growth precisely matched inflation, leaving the investor with the same purchasing power as before. A negative real return, however, signifies that the investment did not keep pace with inflation, leading to an erosion of purchasing power even if the nominal return was positive. For instance, if a savings account offers a 1% interest rate while inflation is 3%, the real return is -2%, meaning the investor can buy 2% less with their money than a year prior. Investors should always strive for investments that are likely to yield a positive real return over their investment horizon.

Hypothetical Example

Consider an investor who purchased shares of equity for $1,000 at the beginning of the year. Over the year, the stock appreciated by $80 and paid $20 in dividends, making the total value of their investment $1,100 at year-end. This represents a nominal return of 10% ((\frac{$100}{$1,000})).

During the same year, the overall inflation rate, as measured by the CPI, was 3%. To calculate the real return on this investment:

1. Calculate Nominal Return:
   Nominal Return = ((\frac{\text{Ending Value} - \text{Beginning Value}}{\text{Beginning Value}}))
   Nominal Return = ((\frac{$1,100 - $1,000}{$1,000})) = 0.10 or 10%

2. Apply Real Return Formula:
   Real Return = (\frac{(1 + \text{Nominal Return})}{(1 + \text{Inflation Rate})} - 1)
   Real Return = (\frac{(1 + 0.10)}{(1 + 0.03)} - 1)
   Real Return = (\frac{1.10}{1.03} - 1)
   Real Return = (1.06796 - 1)
   Real Return = (0.06796) or approximately 6.80%

Even though the investor saw a 10% nominal gain, their real return was 6.80%. This means their purchasing power increased by 6.80% after accounting for the rising cost of goods and services due to inflation.

Practical Applications

Real return is a fundamental concept across various aspects of finance:

• Retirement Planning: Individuals planning for retirement must consider real returns to ensure their savings will provide sufficient purchasing power decades into the future. It's not enough for a portfolio to grow; it must grow faster than inflation to support future expenses.
• Fixed-Income Investments: For instruments like bonds, understanding the real yield is crucial. A bond offering a 4% yield may seem attractive, but if inflation is 3%, the real yield is only 1%. Treasury Inflation-Protected Securities (TIPS) are a prime example of a security designed to offer a real return, as their principal value adjusts with the Consumer Price Index.
• Economic Analysis: Central banks and economists closely monitor real interest rates, which are a form of real return, to gauge the true cost of borrowing and the incentive to save. The Federal Reserve Bank of St. Louis provides data series for real interest rates, such as the 10-Year Real Interest Rate, which reflects market expectations of inflation over the bond's term.³
• Performance Evaluation: Investors and fund managers use real returns to compare the true performance of different investments or funds over time. This metric eliminates the distortion caused by varying inflation rates across different periods, allowing for a more accurate assessment of an investment's ability to generate wealth.
• Government Policy: Governments and policymakers use real return analysis when evaluating the effectiveness of fiscal and monetary policies, particularly their impact on the economy's growth and citizens' living standards.

Limitations and Criticisms

While essential, the real return concept has certain limitations. One primary challenge lies in accurately measuring the inflation rate that is truly relevant to an individual investor. The Consumer Price Index (CPI), commonly used to calculate inflation, represents a weighted average of goods and services consumed by a typical urban household. However, an individual's personal inflation rate may differ significantly based on their unique spending patterns. For example, a retiree might face a different inflation basket than a young professional, leading to a discrepancy between the reported CPI and their actual erosion of purchasing power.

Another criticism stems from the fact that historical real returns do not guarantee future performance. Past periods of high real returns may not be replicable in different economic environments. Furthermore, the calculation of real return does not account for the impact of taxable income on investment gains. Taxes reduce the actual amount of money an investor keeps, meaning the "after-tax real return" is often lower than the calculated real return. This is particularly relevant for investments like interest income or non-qualified dividends.

Additionally, academic research suggests that inflation can affect how investors perceive and value corporate earnings. A study published by the National Bureau of Economic Research (NBER) indicates that inflation may reduce the "earnings relevance" for investors, making it harder to assess a firm's true prospects when accounting relies on historical cost. This can complicate the interpretation of real returns in equity investments.² The impact of market volatility can also obscure real returns, as short-term price fluctuations may overshadow long-term real gains or losses.

Real Return vs. Nominal Return

The distinction between real return and nominal return is fundamental in finance.

While nominal return provides a straightforward measure of an investment's monetary gain, it fails to consider the change in the cost of living. This can lead to a deceptive sense of financial progress. For instance, an investment with a 5% nominal return during a period of 6% inflation would result in a negative real return, even though the investor sees more money in their account. Understanding this difference is crucial for effective long-term financial planning, as it helps investors prioritize maintaining or growing their purchasing power over simply accumulating more dollars. Many investors discuss the importance of focusing on real returns for long-term financial goals.¹

FAQs

Why is real return important for investors?

Real return is important because it indicates whether an investment has genuinely increased an investor's purchasing power after accounting for inflation. It helps investors understand if they are truly getting wealthier or just keeping pace with rising costs.

Can an investment have a positive nominal return but a negative real return?

Yes, absolutely. If the nominal return on an investment is less than the rate of inflation, then the real return will be negative. This means that while the monetary value of your investment increased, your ability to buy goods and services decreased.

How does real return relate to long-term financial goals?

For long-term financial planning, such as saving for retirement, focusing on real return is critical. It ensures that your savings grow sufficiently to support your desired lifestyle in the future, despite potential increases in the cost of living due to inflation. It helps maintain the real value of your investment portfolio.

Does real return account for taxes?

No, the standard real return calculation does not account for taxes. The calculated real return is a pre-tax figure. To get a complete picture, investors should consider their "after-tax real return," which further reduces the gain based on applicable taxable income rates.

What factors typically influence real return?

Real return is primarily influenced by the nominal return of an investment and the prevailing inflation rate. Other factors like interest rates, economic growth, and central bank policies also indirectly affect real returns by impacting nominal returns and inflation.